Friday, March 09, 2012

This past Tuesday, Ed Kleinbard came in from USC Law School to discuss his paper, The Sorry State of Capital Income Taxation. A packed house greeted the brief return of one of New York's most eminent (within the tax field) prodigal sons.

The paper discussed Ed's corporate integration / general business and income tax reform proposal, the business enterprise income tax (BEIT), along with his recent work concerning dual income taxes (which try to separate labor income from capital income in closely held companies), the new features being (a) discussion of how they might be combined and (b) of their relevance in the new tax rate environment that we may face in the near future. Today, of course, the top individual income tax rate is the same as the basic corporate rate (35%), but it is very plausible that they will move apart. For example, one could easily imagine a scenario in which the corporate rate dropped to 25%, while the top individual rate rose to 40%. As Ed points out, if the dividend and capital gains rate rose from 15% to 20% (which also has a good chance of happening), then there'd be an odd neutrality under some circumstances.

Case 1, earn $100 through a corporation, leaving $75 after corporate tax. Distribute it as a dividend, leaving $60 after payment of the 20% dividend tax.

Not to make too much of this almost accidental neutrality, however (which requires not only a particular set of rates, but current-year distribution of the corporate profits). Not to worry, however; Ed, while mentioning it, doesn't make too much of it.

Despite the new features in the paper, a key reason for reading it is to learn (or remind oneself) about the BEIT, which is not just a corporate integration proposal but a comprehensive plan to address how capital income is taxed under U.S. law. It would get rid of numerous formal distortions under current law (e.g., corporate vs. non-corporate and debt versus equity). In addition, it would convert the entity-level corporate tax into the equivalent of a cash-flow consumption tax, while reserving actual income taxation (in the sense of taxing the pure return to waiting) for application at the individual level.

Instead of literally applying cash-flow consumption tax treatment at the corporate level, the BEIT provides a corporate cost of capital allowance ("COCA") that is sometimes known in the literature as an ACC (allowance for corporate capital). A mere allowance for corporate equity (ACE) allows interest-like deductions on corporate equity, but continues to base interest deductions for debt on the instrument terms. So debt vs. equity may still matter under ACE.

Ed's ACC ignores all financial instrument labels, and simply applies an interest deduction to a corporate or other business entity's "inside basis" (that is, all the capital it has received but not yet deducted). With the proper interest rate, this creates present value equivalence to expensing all business level cash outlays - since, the disvalue of deferring the deduction of an outlay, rather than expensing it, is precisely offset by the time-value deduction.

In a sense, this can make inside basis entirely irrelevant. For example, if Congress enacts accelerated depreciation for some assets, this creates no tax preference for them relative to others, since the assets with slower depreciation result in greater basis that yields the business an interest deduction. Likewise, while Ed fully taxes the gain when one company buys another (e.g., suppose Microsoft bought Facebook, generating an enormous tax liability since Ed would repeal all tax-free corporate reorganization rules), the detriment would be precisely offset by having a higher basis that would start generating interest deductions. (In asserting equivalence, I ignore the possibility of tax rate changes, as well as of applying the wrong interest rate.)

In principle under this approach, one could make basis changes wholly elective (leaving aside all the real world issues, such as rate changes). Arbitrarily deciding to declare $1 billion of gain would be equivalent to paying $1 billion for a government bond that paid a market interest rate. Arbitrarily writing down all inside basis to zero would be equivalent to borrowing from the government the amount of the current year tax saving, at a market interest rate.

The individual level works quite differently, however. What one might call people's "outside" basis - that is, the amount they have paid for all of the financial assets they hold - likewise gets an imputed rate of return, only here it's positive (an income accrual) rather than a deduction. Ed anticipates that this will raise net revenue, even when considered jointly with the business-level COCA deduction, because people trade their financial assets comparatively rapidly.

The BEIT would impose zero tax on individual-level capital gains. But there would still be a tax detriment to the sale of an appreciated asset, and a tax benefit to the sale of a loss asset. Thus, suppose that I am holding GE stock with a basis of $100 and a value of $500. If the assumed rate of return that leads to income inclusion at the individual level is 5%, I am currently accruing only $5 per year. But if I sell it to you for $500, then, even though I pay no tax on the sale, you will start accruing income of $25 per year.

Among the implications of this is that there would still be "strategic trading" by investors, who would be inclined to hold the winners and sell the losers. (It would come to an end at death, however, since Ed proposes that the BEIT include a "fair market value" reset at that time. This may sound like a tax benefit, like the tax-free step-up in basis at death under current law, given the absence of a capital gains tax, but in fact it's a detriment for the reason noted above.)

Anyway, this in turn suggests that, if the BEIT was enacted, there would still be a need for such features of current law as the wash sale rules (which deny loss recognition on the sale of an asset that you repurchase within 30 days). Only, what the rule would do is deny the basis reset, since the loss would not be directly allowed.

Likewise, consider the capital loss limitation, which provides that individuals generally cannot deduct capital losses to the extent in excess of capital gains (an annual $3,ooo net loss allowance aside). One presumably would still need something like this under the BEIT, since in its absence smart investors would sell all their losers while holding all their winners. The revised form of the rule might deny negative basis resets to the extent in excess (by some permitted minimum amount) of positive basis resets.

Final question (for extra credit): Why does the corporate part of the BEIT work better than the individual part, so far as realization timing is concerned? The answer, of course, is that the corporate part is a consumption tax, while the individual part is an income tax, so realization timing matters for the latter in a way that it doesn't for the former.

About Me

I am the Wayne Perry Professor of Taxation at New York University Law School. My research mainly emphasizes tax policy, government transfers, budgetary measures, social insurance, and entitlements reform. My most recent books are (1) Decoding the U.S. Corporate Tax (2009) and (2) Taxes, Spending, and the U.S. Government's March Toward Bankruptcy (2006). My other books include Do Deficits Matter? (1997), When Rules Change: An Economic and Political Analysis of Transition Relief and Retroactivity (2000), Making Sense of Social Security Reform (2000), Who Should Pay for Medicare? (2004), Taxes, Spending, and the U.S. Government's March Towards Bankruptcy (2006), Decoding the U.S. Corporate Tax (2009), and Fixing the U.S. International Tax Rules (forthcoming). I am also the author of a novel, Getting It. I am married with two children (boys aged 16 and 19) as well as four (!) cats. For my wife Pat's quilting blog, see Patwig’s Blog.